Market Commentary - June 2021

Monthly Update

The S&P 500 is now riding a 5 month winning streak and is putting in an impressive full year performance in just the 1^st half of 2021. Optimism with a full reopening of the US economy, and a trend towards one overseas, remains the main catalyst. Yes, there is a new Covid variant that we are dealing with but thus far it has been proven the current vaccines are effective. We need to get more people vaccinated and we are headed in that direction. This said, there was some bifurcation under the hood of the market in June. Growth stocks rallied, led by tech, while value stocks were down. The Fed opened the door to potentially trimming to their asset purchase program which resulted in another rotation. European stocks rallied as well, but Asian markets were more mixed.

I mentioned the global reopening as the ‘main’ catalyst, but I also believe that there is a growing consensus that the high inflation we are currently experiencing at both the producer level as well as for consumers is only a temporary phenomenon. If that is the case, the current price jumps will soon resolve themselves and mean revert. That would be a relief to not just businesses and wage earners, but also for the Federal Reserve. While the US economy is far away from the Covid emergency of last year, monetary policy is still running at an emergency pace. If the inflation is not so transitory, the Fed could be forced to tighten policy sooner than they plan. I am not in the transitory camp. I think inflation will remain more sticky than currently believed and when trying to figure out and predict markets and the economy in the 2^nd half of 2021, I think their behavior will be determined by the direction of inflation, inflation, and inflation.

With respect to US interest rates, long end rates fell but we saw a jump in short rates as the June Fed meeting revealed a committee that has started to talk about tapering its asset purchases. Also, more members felt that the first rate hike should take place in 2022 instead of 2023[1]. This flattening of the yield curve also coincided with a US dollar rally, and a selloff in commodity and cyclical related stocks[2]. If the Federal Reserve is about to embark on a ‘removal of easy money’ policy, however glacial that process will be, the assumption is that it will eventual slow economic growth.

Inflation

Whether you are in the market for a new home or car, or are just interested in renting or getting a used car, or just trying to fill the gas tank or fill your shopping cart at the local grocery store, chances are high that you are experiencing some sticker shock. What we have right now is the classic definition of inflation, that being too much money chasing too few goods. On the supply side, supply chains have been splintered due to a lack of parts and labor and in response to the high cost of raw materials. We can also add in the exploding cost of transportation, whether via truck, ship, rail or air. Good luck getting what you want, where you want it, when you need it. On the demand side, the world is coming back to work, and in the US too, very generous government transfer payments have replaced the Covid related wage losses and then some. We are also now seeing notable increases in wages as with a record number of job openings in the US, employers cannot find enough workers[3]. Higher wages are certainly great for employees, but can squeeze profit margins and lead to higher consumer prices if companies cannot offset the higher costs with more efficient productivity.

The biggest question on hand is whether this inflation spike, where core CPI is running at an annualized rate of up 7.6% over the past three months and producer prices are rising at an 8.4% pace also over the past three months, is temporary or not[4]. If it is not temporary, it will slow economic growth, which it already is in certain sectors like auto production and housing. The former cannot get enough semiconductor chips, and the latter is seeing aggressive price increases approaching 15% that are slowing the pace of transactions as buyers call a time out[5]. This all may lead to higher interest rates and pressure the Fed to respond with more aggressive tightening than they are currently planning for.

Interest Rates

One of the market’s challenges with a bout of sustained higher inflation is the current low level of interest rates both in the US and also globally. They are below zero in Europe and Japan as there are $13 Trillion worth of bonds around the world with a negative yield[6]. Thus, there is no interest rate cushion or shock absorber to handle upside inflation surprises. The months and quarters ahead will therefore be so important in, not just seeing whether inflation remains more consistent, but also what will be the central bank response function.

Outside of the very large developed central banks that mostly remain full speed ahead with aggressive monetary policy, we did see a shift in policy in June as some began the process of rate normalization. Central banks in Brazil, Mexico, Russia, Hungary, and the Czech Republic all raised interest rates, and the Norges Bank in Norway and the Bank of Korea set the stage for rate hikes in Q3[7].

The level of corporate interest rates remains historically low. The economic rebound and asset price rally further tightened credit spreads and lowered yields. The Bloomberg Barclays High Yield bond index is yielding just 3.78% as of this writing on a yield to worst basis[8]. This should no longer be called ‘high yield’ and maybe junk is the right reference instead. That spread to US Treasuries is the narrowest since the summer of 2007[9]. The CCC bond index from Bloomberg Barclays has a yield of just 5.76%, which compares with the 25 year average of 12.8%. This rating category is just above D for Default[10].

The Economy

The US economy saw GDP growth of 4.3% in Q1 and the Atlanta Fed’s GDPNow tracker is currently predicting 8.3% for Q2[11]. The question is whether this is peak growth as while spending on services is accelerating, we have to wonder how sustainable the recent strength in spending on goods will be after such a sharp increase over the past year. Also with respect to both goods and services, we have the issues of supply. For goods there are all of the issues mentioned above and in services we see employers who cannot find enough workers to fully staff up and expand.

The inflation which the US economy is currently feeling is a global phenomenon. Other parts of the world, particularly Europe and Asia, are experiencing similar things. Also, I hate to use the word ‘stagflation’ but we are seeing it in certain parts of the economy.

I specifically want to talk about housing and autos, as they contribute a huge amount to the US economy. The demand for autos is strong, but unfortunately there are not enough new cars for sale because a shortage of semiconductors slowing production. In turn, this is leading to higher prices to the point where some cars are being sold above the MSRP. As inventory of new cars is light, used car prices are exploding higher, as consumers shift their spending to this category. According to the Manheim Used Vehicle index, prices spiked by 36% y/o/y in June[12].

With respect to housing, there is a dearth of inventory of existing homes and supply issues are limiting the supply of new ones. The end result was a nearly 15% y/o/y home price gain in April according to S&P CoreLogic. That is making it more challenging for 1^st time buyers to own a home, as they are forced to come up with more of a down payment. These aggressive price gains has wiped out the benefit of low mortgage rates.

I bring up these two sectors, not just because of their outsized contribution to economic activity, but because they are the two most interest rate sensitive sectors and thus most influenced by Federal Reserve policy. Therefore, not only are inflation and supply issues impacting housing and autos directly, the direction of interest rates from here will also be a big influence on the path forward for them.

Conclusion

It has been an impressive six months for markets with enthusiasm for a return to normal at the same time central banks remain extraordinarily easy. At the same time, we are currently experiencing the most intense inflation story since the 1970’s, with interest rates around the world microscopic and asset price valuations very high. As stated, this inflation story is either transitory or not, and answering that question is now key to the tenor of the investing landscape as we look to the back half of 2020. I believe what we are seeing is not so transitory and think that interest rates will resume their trend higher with central bankers badly lagging in pulling back their money printing.

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on these markets.

Disclaimer